On Pricing, or Why Are Customers Using Your Product?
Inflation is on everyone’s mind. Supply chains are stretched; prices of inputs for most businesses are up by double digits. Many consumer businesses I talk to are in a difficult spot: margins are severely compressed; and yet they’re concerned about making a bad situation worse by raising prices. They’re uncertain about what that’d do to customer retention - and afraid of damaging their brand.
On the surface, the situation looks unprecedented; inflation hasn’t been this high for 40+ years. Most consumers expect inflation to remain elevated for years to come. Business leaders find themselves in, seemingly, a once-in-a-generation quandary.
And yet, decisions on pricing come down to a simple question: do you understand why customers are using your product? What makes them choose you over the alternatives? Alternatives don’t necessarily mean “direct competitors” - an alternative might be buying nothing.
Don’t rush to answer. In many cases, it’s not as evident as it seems. Let’s look at some examples in the consumer space.
1. Consumer Deal Sites. Why were Groupon, Living Social, and many copycats so popular with consumers a few years ago? Why were they buying up yoga classes, followed by cooking classes, and everything else in between? Was it because they really wanted to go to a yoga class? Heck no - if they did, yoga classes were available for online registration for years before Groupon. Customers buy stuff on Groupon for the same reason why they go to Marshall’s, eBay, or restaurant week. They love a deal. That’s the primary driver.
If they love a deal, can you raise the price on them? Nope.
2. Restaurant Delivery Services. Why are customers ordering McDonalds for delivery? It’s quite expensive - the delivery fee, service fee, and driver tip can add up to as much as the cost of the food itself. And yet, consumers pay up. Don’t forget - McDonalds is not a luxury restaurant, most customers who shop there aren’t affluent. Why then do they pay all of these extras? Because they value convenience above all else.
Can the likes of Doordash raise prices? Yep.
3. Meal kits. Why are consumers ordering Hello Fresh and Green Chef boxes that arrive a few days out, when they can get Instacart or Amazon Fresh in 2-3 hours? Why are they paying more for those groceries than what they could get at a local grocery store? Clearly, consumers value these services for some other reason. Reduction in cognitive effort from meal planning; discovery of new recipes is also valuable; someone doing the measuring of the ingredients for them is another.
Could some of these services raise prices? Maybe! Danger zone here when competitors (ex. local grocery stores) offer similar value. Kroger owns Home Chef, don't forget.
4. Home Gym Services. Why are consumers using services like Peloton, Mirror, and others, after COVID restrictions have been lifted and gyms have broadly reopened? Surely, the pandemic brought some transient demand that has now disappeared, but people that are still using these services today are in because it’s much more convenient for them to not need to drive to the gym - even if the cost is roughly the same.
Can Peloton raise prices without risking tremendous churn? Probably yes.
How do you find out whether your business has relatively price-insensitive customers that will tolerate an increase? In my mind, this starts with user research:
Run some qualitative studies - half-hour interviews of a dozen existing customers. Find out why they’ve chosen your product; what alternatives they know of; and what they value most about your service after using it for a while. The key here is understanding the customers’ context - the jobs to be done - that your product fits into. Quotes from these interviews will become your hypotheses to validate in the next step.
Follow up with a quantitative study - a large-scale survey of a thousand+ existing customers where top answers from the interviews are presented in a multiple-choice form. This is where you narrow down your “why do they buy” hypothesis set into 2-3 concrete concepts. If these turn out to be a bit removed from monetary value, great; if you end up raising prices, make sure to heavily emphasize these value propositions to your customers in your product and marketing.
A company with tens of millions in revenue cannot afford to not have a full-time user researcher - someone whose job it is to run studies like this. Even if you don’t have a user research specialist on staff, a product manager, or a marketer, can do a rudimentary version of this exercise and get you well on your way.
What do you do afterward, if your leading hypothesis is that a price increase is the right next step:
Run some A/B tests on just new customers, if possible. New customers don’t have an expectation of what your service “should” cost / no anchoring to what it cost just yesterday, so observing conversion differences between different price points for different customers is a great “two-way door” that you can easily go back through if things go awry. Experiment with multiple versions of prices. If your inputs are up by 10%, don’t just increase prices by 10% in an A/B test. Try 7% and 13% - see if you can experimentally figure out the shape of the demand curve (how demand changes with price). This curve won’t be linear; optimization is possible.
Be particularly careful with existing customers. It may not be worth it to touch them at all; you may want to do segmentation here. One thing is certain: you don’t want to do multiple rounds of price increases on existing customers within a short time window (my rule of thumb: no more than once a year). Psychological backing here is “combine all the bad news all to one occasion” - if you have to do a price increase, do just one and create some room for yourself to not need to do another one.
How you communicate the price increase to existing customers really matters. Focus on giving them control, if possible - present the price increase as a choice (ex. “you can enjoy lower prices by buying a bigger package…”). Give advanced warning. Be frank and direct with customers, talk about why the increase is happening (your costs are up? say it!).
Finally, some caveats:
Every service has price-conscious customers, even if the majority isn’t. They will be the ones to churn. The churn from a price increase will never be zero.
Every product has some price sensitivity to it. That is, even the most convenience-forward service can raise prices only up to a point - after that, demand falls off the cliff. People will begrudgingly pay a $15 delivery fee to get their burger to their door, but not $50. At $50 per delivery, Doordash demand would probably drop to near zero.
Don’t think of churn as a binary event, i.e. “they stay or they churn.” Customers can also (1) reduce their order size in response to higher unit prices and (2) reduce their purchase frequency. When you run your tests, watch out for both of these behaviors.
Just communicating to the customer that price is changing - even by 1% - will cause churn as it’ll be a moment of re-evaluation of what your service really brings them.